ICOs: Compelling Advantages, Real Risk

Joshua Cook and Mike Heath are corporate and securities attorneys at business law firm Gunderson Dettmer, where they specializes in the representation of emerging growth companies and private equity investment funds.

In this opinion piece, Cook and Heath give their view on developments in the fast-growing blockchain use case, noting the ways the tech augments the traditional fundraising process – for better and worse.

Are ICOs ready to disrupt the VC world? Spoiler alert: not yet.

I’ve spent my entire career doing venture deals for tech companies and I know the good, bad and ugly of fundraising. I’ve also seen private company shareholders, frequently small ones, stuck holding onto private company stock because there’s never been an efficient way to sell it.

In the bad ol’ days (i.e. like six months ago), the development path for a software startup looked a bit like this:

Step 1: Incorporate

Step 2: Build team and product, generate revenue and huge user base

Step 3: Entice a VC to buy ~25% of your equity

Step 4: Repeat step 2 and step 3 at increasing values and bigger user base numbers until you can sell the company or take it public.

Token sales (also known as initial coin offerings – although your lawyer hates it when you call them that) seem to offer a great hack.

While VC firms expect to see a functioning product before investing, some software companies are raising millions on a white paper. And while not every project is an obvious choice for blockchain, certain network effect companies that once relied on scale to attract VCs are short-circuiting the process by selling tokens instead – in some cases raising 10x the value in 1/10 the time.

That inverted math has many firms and investors struggling to figure out if they should get in on the token rush.

Advantages and risk

Tokens have some compelling advantages over a conventional equity financing for both issuers and purchasers:

If it’s not a security (and that is the $64 billion “if”), you can make a public offering with press. Securities laws restrict most traditional venture financings only to accredited investors and prohibit publicly marketing the offering to drum up demand.If offerings were opened up to anyone with an internet connection, it might democratize venture investing the way Facebook democratized news editors (for better AND for much worse). It could also unleash the long tail of the retail buyer – although there’s certainly a policy discussion to be had about whether that’s a good thing.

Tokens are liquid. So long as there is a functioning crypto-exchange, tokens are much more liquid than private company stock. And because crypto markets are more transparent, you’re actually able to see global asset prices in near real-time. Private company equity markets are more or less totally illiquid. The transactions that do occur are typically complex, slow and comparatively large.

But, and it’s a big but…

It can be very tax inefficient for issuers. When a company sells equity to raise money, it doesn’t pay any income tax on the proceeds. When a company raises money through a token sale, the proceeds are treated as revenue, and therefore subject to tax. In the U.S., you’d expect to pay roughly 40 percent of every dollar raised. While some sales may be structured through tax-exempt and/or offshore entities, that structuring is more expensive, more complicated and riskier than a traditional venture financing.

Issuers have little regulatory certainty (i.e. you might not know that you’re breaking the law, but ignorance won’t be a defense). Even after the Securities and Exchange Commission (SEC) weighed in with the catchily titled “Release No. 81207 / July 25, 2017: Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO,” there is still significant uncertainty as to whether a token is a security. The SEC declined to provide a bright-line test, instead emphasizing that each sale must be considered individually.
To further complicate matters, while the focus to date has been on the SEC’s position, the SEC is not the only potential actor in enforcing securities laws. Plaintiffs’ attorneys, state attorneys-general and state securities commissioners will all take an active interest in these sales. In response to the regulatory uncertainty, we are seeing projects like Filecoin voluntarily choosing to run its SAFT offering in compliance with Rule 506(b) and Rule 506(c) for their pre-sale and public sale respectively (i.e. accredited investors only.)

If an issuer is trying to “do it right,” a token sale is (as of now) slower and more expensive than raising an equity round.Many projects are providing their buyers with a terms-of-sale document, which reads like a mini-IPO prospectus. Preparing one is a fact-specific undertaking that needs to be tailored to each project. This costs money.
Since these token sales are often global offerings, more risk-averse issuers choose to run regulatory and tax analyses for each jurisdiction they may sell into (e.g. Japan, Canada, Germany) as well as the U.S. This costs more money.

You’re a token holder and you lost your private key? Oh well. In conventional financings, the issuer is a trusted third party. If you lose your stock certificate, the issuer will almost always give you a new one if you pinky swear that you really lost it. But if you lose your private key for your wallet or if your wallet is otherwise compromised, welp … that sucks.
While it’s axiomatic that “trusted third parties are security holes,” in my experience, there’s often another security hole, and it’s sitting between the chair and the keyboard. Multi-sig wallets and other innovations may help blunt the risk of loss for a token holder, and people might be more careful with the assets if they know there’s no pinky swearing in crypto, but only time will tell. One thing that we know for sure is that there’s no “lost crypto affidavit.”

A financing model without VCs?

But let’s assume that the market gets comfortable with the drawbacks around a token sale; the SEC gives clear guidance that token sales aren’t securities offerings, and public token sales displace conventional venture financings – at least for certain software companies. In that future world, venture capitalists will be totally disintermediated, right?

I’m not so sure about that. Venture funds already provide something of a curation function in the Wild West of token sales. Filecoin notably (and not without controversy) ran a pre-sale with a number of top-tier venture funds participating. Likewise, Bancor touted Tim Draper’s involvement with its token sale. Rightly or wrongly, a particular fund’s participation in a token sale seems to give a project a stamp of legitimacy.

Although anecdotal, I am seeing people (myself included) drawn to token sales who do not have the technical chops to evaluate a white paper. Proof-of-spacetime sounds amazing, but let’s be honest, I don’t know if a “tuple of polynomial-time algorithms” is the right approach to the problem because I don’t know what a “tuple of polynomial-time algorithms” is.

But if I know that the venture funds that backed the companies that built the internet are backing a particular blockchain project, then maybe I’ll defer to their opinion on polynomial-time algorithms.

The token sale phenomenon has incredible potential, but it’s still in its infancy. I can imagine a global token market parallel to conventional equity markets with similar liquidity and speed of execution.

Sure, token sales have lousy tax treatments, questionable regulatory structures and a legal bill that dwarfs a conventional venture financing, but these are growing pains of a nascent market.

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